By: Gregory T. Huang

Every once in a while, an investment model comes along that turns the innovation community on its head. The venture capital industry, still less than 50 years old, is one example. Now an emerging paradigm called royalty-based financing, applied to early-stage startups, may be another. The approach has its roots in the Boston area, and is starting to generate some serious buzz in the Northwest. If you’re a VC, angel investor, or entrepreneur, it definitely needs to be on your radar.

The concept of royalty-based financing is simple. Instead of buying equity in a young company, an investor agrees to receive a percentage of the company’s monthly revenues—up to a limit of, say, three to five times his or her investment. Instead of waiting five or 10 years for a startup to go public or get acquired, an investor can start seeing returns almost immediately. This approach means investors should be able to fund a much wider range of startups than just those that typically receive venture backing—the ones that have potential to grow huge, fast. The downside is that your returns are capped, so if you do end up backing the next Google or Amazon, you still only get five times your investment back. Meanwhile, for entrepreneurs, it provides startup money without having to give up an ownership stake in the company.

Royalty-based financing is not new, but it’s only been in the past few months that investors around Seattle, including the seed-stage fund Founder’s Co-op, have been openly exploring the model. In New England, a few investment firms are actively using it, led by Lexington, MA-based Royalty Capital Management, Wakefield, MA-based BDC Capital, and Portland, ME-based Rockwater Capital. Harvard Business School professor Clay Christensen (of The Innovator’s Dilemma fame) is a supporter of the model, and views it as disruptive to the venture capital industry.

The idea actually dates back to mining companies getting financed to dig for oil, natural gas, and minerals, and government-funded economic development programs. But it is getting renewed interest from VCs and angel investors who increasingly need returns fast, in a tough climate for exits. Indeed, royalty-based venture financing “has the real potential of becoming a major new sector in the private capital market,” says Arthur Fox, the founder of Royalty Capital Management, who first used the approach with startups in the early 1990s.

Back then, Fox was an advisor to several startups; he’s an MIT alum and was previously an engineer with HP and Westinghouse before co-founding three tech companies of his own. He first tried out the royalty-based idea as a way to get compensated by the companies he was mentoring, instead of taking some stock. He found that this made them more efficient with his time, plus he would get paid every month. So he decided to try out the strategy as an investor. “It changed everything, because the normal criteria in selecting companies as a venture capitalist is a high-growth one,” Fox says. “When you invest in a company, buying stock and equity, you have no way of getting out unless they become significantly large enough to have a liquidity event.” With the new approach, he says, “every month you get a check, and it doesn’t matter if they ever have an IPO, or get bought out.”

Fox’s two previous funds have returned good profits. His biggest win was Andover Advanced Technologies, a multimedia software startup that had no revenues when he originally invested $100,000 in 1993. After two years, Fox had gotten back $125,000 in his cut of the revenues, and he invested in a second round with an angel investor, in which he took some equity. The company (renamed Andover.net) went on to ride the dot-com wave with a successful IPO in 1999, and was acquired for $1 billion by VA Linux Systems in 2000. Fox’s stock ended up being worth $15 million. It’s an example, he says, of how “royalty investment lets you get your foot in the door, evaluate how the company is really doing, how management is doing, and you may have the opportunity to participate in a follow-up round with much more knowledge.”

Of course, it also points out that if you want a home run, you need a conventional equity-based deal. And that’s the main objection most venture capitalists have with the royalty-based approach. While it may broaden their options of who to invest in, it goes against the high-risk, high-reward approach they’re used to. They also wonder why more investors aren’t trying the approach, if it’s so successful.

But this ignores the dire reality of today’s financial markets, says Thomas Thurston, the founder of Portland, OR-based Growth Science International, a research and consulting firm focused on predicting whether businesses (everything from startups to public companies) will survive or fail. “Venture capitalists say, ‘I don’t know if I’m comfortable capping [returns] at 5x,’” Thurston says. “But on the other hand, you’re probably not getting 5x right now, so you’d be perfectly happy.”

Thurston has recently helped bring the ideas of royalty-based financing to the Northwest. Originally trained in law and business, Thurston was with Intel Capital when he was invited to do a year-long research fellowship at Harvard Business School with Clay Christensen in 2007, focusing on rigorous tests of Christensen’s disruption theory (that’s worth a separate story). One of the many ideas the two came across was royalty-based financing, through meeting with Fox back East. Thurston has since been working with Christensen on a study of royalty-based financing. He concludes that “there are enough circumstances where it really is a good tool,” given the traditional limitations VCs face.

“So for that reason, I think it’s very fun,” Thurston says. “No longer is funding gated by the likelihood of an exit. That’s very significant.”

Perhaps what’s most interesting about the approach is that it could enable many more kinds of startups to get off the ground, and more young companies with revenues to grow. That’s compared with the 2 percent or so of all businesses that would be attractive to a VC. Given the difficulty entrepreneurs are facing these days to get seed- and early-stage funding, it could be a perfect match. “The alternative for a lot of businesses is nothing. It’s awesome for the entrepreneur,” Thurston says. “It gives you less pressure to grow and sell.”

Looking to the future, Thurston thinks that while some intrepid VCs will try out the royalty-based approach, angel investors “will be the ones who do the earliest experimentation and start to prove it out.” That’s in part because they don’t usually have limited partners to confirm it with. “I think it’ll feel less sexy to a VC,” he says. “But to VCs who are innovative, they’ll say, ‘Sexy or not, I like getting good returns.’ Imagine being a VC, you make an investment in September, and by October you’re getting revenues.”

Fox, for his part, says his next step is to raise a larger fund in the Boston area, probably on the scale of $25-50 million, and then start pools in other geographical areas. The idea would be to invest $1-3 million in emerging companies that are doing a few million dollars of revenue a year (“there are a lot of them,” he says). Fox says he’s still looking for the right partners.

So is royalty-based venture financing poised to take off in the Northwest, and beyond? “I would love it, but I’m heavily biased,” Thurston says from Portland. “I’ve been focused on predictions. There is momentum happening in my small world, and people are wanting to hear about this.”

Gregory T. Huang is Xconomy’s National IT Editor and the Editor of Xconomy Boston. You can e-mail him at gthuang@xconomy.com, call him at 617-252-7323, or follow him at twitter.com/gthuang.